One of the narratives flying about as to why gold is on a tear is because of hedging against inflation.

Over the years, gold has been seen as a price stability mechanism; a tangible way to counteract the inflatory policies of central banks...

It predominantly has this tag because it's priced in dollars...

I don't necessarily buy that, since over the past few years, we've seen widespread deflation across the globe, and more recently, deflation has been exported from China due to the Yuan depreciation.

There is an issue that I see with the view that the policies of the central bankers and governments will simply lead to inflation over the next few years...

Which may narrow down our reasoning as to why we should or shouldn't be long gold and from a broader perspective, metals in general.

David, what are you on about?

We'll get into a little bit of economic theory first.

The Theory of the Quantity of Money was suggested by Copernicus back in the 16th century and furthered by many economists and philosophers since...

Friedman, Schwartz...

Locke and Hume...

They all had contributions here.

The quantity of money theory boils down to this though...

MV = PQ

M - money supply;
V - velocity of money (or the rate at which people or/and companies spend money);
P - general price level;
Q - volume of transactions of goods and services;


This equation can be transformed as follows:

PQ = MV = GDP (nominal)

or...

V = GDP / M

or...

GDP = V * M

These are all different ways of saying that an increase in the velocity of money leads to higher inflation and a feedback into higher GDP...

The problem is that this theory has essentially been debunked over the past 10 years.

Take a look at the velocity of money since 2000.

We have seen a constant decline since post DotCom...

Since the velocity of money is based on speed and volume of transactions, in the modern world, you might expect MV to be far higher...

The problem here though is that central bank policies of quantitative easing have created a lot of stagnant money.

This paper highlights the extent to which corporates are sitting on cash...

It's to the tune of $4tn, up from $1.6tn in 2000.

What we are seeing here is that a decrease in rates but a subsequent increase in the money supply broke the relationship between the cost of cash and the amount of money in the economy.

The lowering of the cost of cash leads to there being more stagnant money in the economy; or in other words, the cost of saving decreased, leading to this money turning stagnant and not being 'used' as much in the economy...

This is true for both normal people and corporates.

The conundrum facing central banks now is that it's highly unlikely that they will raise rates, or at least, be able to raise rates since there is a feedback loop of higher rates equalling higher inflation and not actually the other way round.

Think about it.

Their policies til now have led to asset price inflation massively, yet money velocity has been on the floor, whilst economies haven't managed to overheat.

How will an even greater expansion of the money supply lead to money velocity increasing?

I don't think it will.

Why has this happened?

I mentioned above that money has turned stagnant.

The mechanism that this occurs through is essentially the way in which money is deployed.

Excess cash, or liquidity, gets put to relatively idle use where it does not change hands in the actual economy.

The actual economy is where money velocity shows itself.

This identifies a really big problem with central bankers mandates...

Or is it in the design?

Tim, you probably know that central banks look for an inflation rate of 2% +/- 1%...

But they are committing to quantitative easing and asset purchases which...

Affect the price of assets and do not affect the CPI measure they base their policy on!

So central banks providing liquidity, or credit easing, end up having the destination of that policy become ineffectual as it gets stuck at a certain point.

Let's take the example of the Fed buying Treasuries.

They buy a treasury from an investor...

What happens then?

Well, the money just sits on a balance sheet.

It's not actual money, really.

And it's more likely that the investor holding the Fed's capital will change their portfolio slightly to go and buy another asset.

The money doesn't enter the real economy.

Under a stable money supply, the equation does hold true - it mathematically has to.

But to argue that central bank purchases of assets will lead to inflation is kinda wrong, since there isn't necessarily an increase in aggregate demand which will raise money velocity (and GDP and inflation).

What's the alternative?

Well, we could see inflation creep up perhaps.

Central banks have been funding the government.

This is known as debt monetisation.

There is a two pronged issue here.

Firstly, if the government does indeed cause a rise in aggregate demand due to the specific programmes it has undertaken to re-stimulate the post COVID economy, then yes, inflation will increase...

And secondly, if we get to a point where investors are perturbed by negatively yielding debt, then interest rates will have to rise to make bonds more attractive again...

But I'll critique both of these points...

  1. The government are bridging a gap here and I fail to see how attempting to simply plug a hole in demand will lead to a concurrent future rapid rise in inflation (although they may like this temporarily to inflate away some of the debt owed)...

Remember that MV is the key component here and transaction volume is down massively anyway...

And...

  1. No one is fucking perturbed by negatively yielding debt yet.

On this point, as the Fed buys more treasuries, they essentially take previous bonds out of circulation, leading to the remaining bonds being more expensive.

Who will want to be short treasuries when all they have to do is sit on the bid and sell back to market?

You can see this in play by looking at $TLT.

TLT is an ETF that tracks US sovereign debt...

And yes, it looks like the Nasdaq...

What does this mean for the narrative of hyper-inflation then?

Well, I think that narrative falls well short of substance, although I am happy to be wrong.

I simply do not see the case for it being apparent simply based off the assumption that the Fed is increasing the money supply.

In fact, I'd argue it's largely the opposite, which goes against what many commentators are arguing.

This takes a narrative away from the goldbugs in my perspective, but it doesn't mean they are wrong in being long gold or precious metals...

The way I see it, there are MANY geopolitical tensions and domestic issues globally that make being long gold a good ide

The problem though is that most of this is paper traded, so I don't know how truly committed to that narrative people are unless they do hold physical!

I guess we are all speculators though and I take some solace in the fact that many might not really think the world is collapsing in front of our eyes.

Well, there is another answer...

Perhaps what we are and have been seeing is a massive deflation hedge.

I reckon that makes far more sense in context.

And thinking about this while writing has led me onto another broader theme which we will begin discussion with you tomorrow...

And that is a monster industrial metals rally pending...

Food for thought above, but I hope it's given you some insight into what I am thinking (and yes, I thought that we would see inflation back at the start of the year but a lot has changed since then...)